Pop Goes The Bubble

Rising prices are not a sure indicator of value, and a collapse isn't visible until it's happening.

Your Money

April 17, 2005|By John Lux

Bubble, bubble, who's got the bubble? Is it real estate? Commodities? Equities in general? Or none of the above?

Most investors are painfully aware that bubbles burst and can cause pain when they do. Five years ago, lots of investors were burned when stock markets, led by the Nasdaq, went into a tailspin. People who dreamed of a comfortable retirement financed by gains in the market got a shock.

Once-burned, twice-shy investors began moving money out of stocks. Now, many are worried that the investments they chose are bubble-prone, too.

Werner F.M. De Bondt, director of the Richard H. Driehaus Behavioral Finance Center at DePaul University in Chicago, says the fault lies not in the markets, but in ourselves. "People think life is too short and they deserve to be part of a society that becomes richer and richer," he says.

The facts of investing life belie the entitlement mentality. Economists say the worth of an investment must be judged not by the rising prices paid for it but by the investment's earnings capacity.

Jeremy J. Siegel, a professor of finance at the University of Pennsylvania's Wharton School, writes that a bubble is created when the rising price of an asset is not related to its value but is fed by "momentum investors," who buy only with the idea of selling to other investors at a higher price.

It's a fool's game to try to guess when the bubble will burst. De Bondt says. "There are bubbles all the time," he says, "but you can only say it was a bubble after a dramatic collapse in the market, or an industry, or even a particular stock. Nobody can really predict."

Robert H. Parks, professor of finance at Pace University's Lubin School of Business in New York, sees bubbles everywhere today - in stocks, bonds, hedge funds and real estate - and says U.S. monetary and fiscal policies are at fault.

A lot of money is available for investment from baby boomers racing toward retirement, and Parks thinks the last thing the country needs is easy money.

Because the Federal Reserve has been too timid in raising rates, Parks says, "speculators are borrowing short and lending long." Money borrowed at low short-term interest rates is being re-lent at higher long-term rates.

Say that a banker borrows short by issuing a one-month certificate of deposit, then lends long by issuing a five-year auto loan.

"This works only if interest rates are coming down," Parks says. "That's about to come to an end. If you borrow short and lend long just before interest rates surge, you go bankrupt."

Parks is especially worried about all the money going into real estate. The National Association of Realtors says 23 percent of all homes sold last year were bought strictly as investments and 13 percent were bought as second homes, also a form of investment for many people.

"Real estate is a tempting investment," De Bondt says, "because people think they understand real estate. It's not like the stock market, where new prices are recorded every day. People have a false idea that there is less volatility, and this lures people in."

People see real estate as an inflation hedge, De Bondt says, and it is, but only in the long run.

Hal Young, a certified public accountant and a partner with Frank & Co. in McLean, Va., sees big problems on the horizon for individual real estate investors. In a nutshell, buyers are paying more for properties and getting less in rent when they lease them.

"In Washington, D.C., for example, current owners are converting rentals to condos, and current renters who can are buying," Young says. Because mortgages are easy to get, many renters are buying, and there are fewer people who want to rent. "So prices go up for sales, but not for the rents," and the investor can't make the purchase pay, he says.

Historically, Young says, to make an investment worthwhile, real estate investors have looked for a 9 percent or 10 percent rate of return on invested capital. But, because of high prices and low rents, many condos are bringing a 5 percent or 6 percent rate of return. And that assumes that the place never goes without a tenant.

Even worse, Young says, is the outlook for investors who buy second homes hoping to rent them out.

"I see people buying property in the Outer Banks of North Carolina," Young says, "which has a May-to-September rental season. So run the numbers and you can't come anywhere near the right cash flow. You'll be carrying it from October to March. Cash flow can kill you."

Owners end up being slaves to their expensive second homes, scrimping on their usual spending to come up with the mortgage and expenses.

The rise in housing prices is a prime example of the greater fool theory, Young says: Even if you paid too much, you'll make money on any investment if you find a buyer who's a greater fool than you are.

Is there any way to keep from getting caught in a bubble?

Parks thinks now is the time to show the markets your heels. He sees a very bad year ahead for all investments.